Producer Sovereignty and the Irrelevance of Markets

Neoclassical (and Austrian) economics as a whole tend to emphasise market forces as the dominant determinant of employment, distribution and output in the economy. In the neoclassical theory of the firm, firms are something of a ‘black box,’ inside which uniform inputs are uniformly processed into uniform outputs. The firm can be thought of as an agent – or collection of agents – maximising some goal subject to resource constraints. The most commonly used version of this is the perfectly competitive firm, which treats prices as a given, has the single aim of maximising profits and makes ‘normal’ profits. However, even more elaborate theories of the firm – such as ones where managers have objectives that conflict with those of shareholders – retain the standard assumption that the exhibited behaviour of the firm can be deduced from the behaviour of optimising agents inside it. Firms are rarely assumed to have internal differences in production techniques. Instead, they simply serve as channels, coordinated by supply and demand, through which resources are allocated.

But there is good reason to believe producers, rather than the impartial ‘laws’ of demand and supply, are the dominant force in an economy. It is a stretch to suggest that products are merely the expression of consumer preferences; after all, consumers rarely have input directly into the production process. Products are created by a firm and the consumers role is passive in that they can only choose whether or not to reject it. There also exists a power asymmetry between producers and consumers (and workers): since producers are the ones who own the products, they can ‘hold out’ for longer than those without. A capitalist alone can subsist; one who is merely a worker and/or consumer relies on the capitalist(s) for employment, goods and services.

In neoclassical theory, any deviations from perfect competition, and even the mere existence of firms, is thought to be either a source of inefficiencies, a result of them, or both. Hence, an ‘ideal,’ Pareto Efficient economy is thought to be one of perfectly competitive, tiny firms, which have no individual impact on the market in which they are situated. Any questions asked about firms proceed from the premise of which ‘frictions’ we can blame for the observed real world deviation from this ideal.

Several questions about how firms work and their role in the economy are never asked in neoclassical economics. First, what really goes on inside the firm: how are organisation and management used to impact the ability of the firm to convert inputs into outputs? Second, what is the nature of ‘market power?’ Could it be that some industries are so characterised by ‘market power’ that it no longer makes sense to talk about ‘the market’ as a meaningful concept? Third, to what extend do ‘imperfections’ such as these – organisation, market power, scale – actually create beneficial effects that we would not observe in the world of perfect competition?

I believe that, under contemporary capitalism, firms have such an impact that it makes more sense to use ‘the firm’ as an epistemological starting point than ‘the market.’ I also believe that, at least from material point of view, large firms are probably a superior system to one resembling the perfectly competitive ‘ideal.’

The competitive ideal seems illogical when applied to the real world. Market forces can be inherently uncertain and costly to adjust to. Any firm which is wholly subservient to market forces, and hence has no control over its future, is simply a terrible firm, and a poor prospect for any potential investor, shareholder or worker. Even consumers prefer an established brand they can trust, at least in the absence of regulation. Hence, no firm would go to an investor, shareholder or bank and say “I have a product, let’s see whether the market likes it or not;” what is expected is a clear strategy.

It would, of course, be wrong to suggest that firms are not under threat from the development on new technologies and from the demands of consumers. Even well established companies go bankrupt from time to time. Nevertheless, many firms persist for a long time, either because their position is that strong or because they insure themselves against market forces. Research and development can ensure a firm always has something new to offer and can adapt, should demand for a product fall or a new release flop. Horizontal integration – selling different products, perhaps in entirely different markets – can broaden a firm’s consumer base (Google’s massive diversification over the last decade is an example of this). Brand proliferation – the same firm creating multiple brands – can serve a similar purpose (think of the different cereals produced by Kellogg).

The challenge for a firm is to establish a degree of control over its respective market; the degree to which it manages this will be a determinant of its success; its ‘competitive advantage.’ Hence, many of a firm’s actions have the purpose of cementing that firm’s position in the marketplace, rather than simply responding passively to outside market forces. Numerous behaviours exhibited by firms support this idea:

Some firms seek market share as opposed to profits: they want to make sure they have sufficient control over their industry.

Prices don’t change constantly depending on the state of the economy; firms keep them the same for long periods of time to save money when performing calculations and to be able to produce projections.

Branding, advertising, marketing and various offers are used to gain and retain customers so that the firm has at least a minimum flow of demand it can rely on. The mantra that it is far more costly to acquire new customers than retain old ones is well known; hence, firms try to make sure they are as unaffected by the whims of consumers as possible.

Firms control supply through deals, perhaps exclusive, with suppliers; better yet, they can establish control of the supply chain themselves (vertical integration).

Firms also need to establish control over the labour market, as they often rely on the commitment of workers to a specific position in their organisation. The fact that knowledge and skills are often organisation-specific makes the cost of leaving – for both employer and employee – higher, and this effect becomes more amplified as one moves up the hierarchy of the organisation. The result is that the cost of even one worker leaving are often estimated to be well above their salary. It is no use starting a project if you know that, half way through, your manager – with his unique knowledge of what is going on – will just leave and work elsewhere. So firms retain workers with promises of career progression and rewards, as well as establishing a psychological commitment to their organisation. The most extreme example of this is the Japanese ‘employment for life‘ approach, which has proved to be remarkably competitive; moreso than many of its western counterparts.

The existence of long lived companies with significant influence over forces supposedly determined by ‘the market’ creates another problem for the state-market dichotomy. Many companies are economically bigger than countries or state and local governments, and hence their decisions have considerable political implications. A large company setting up shop in a small town, or even small country can significantly alter the landscape there.

Unfortunately, many supporter of “free markets” are driven to defending the actions of large, centralised entities as apolitical. This perspective is based on the false premise that they are simple conduits for scarcity and consumer preferences, rather than actively determining and influencing these things. It is clear this influence has largely driven us away from what economists typically mean when they speak of a ‘market.’ The implication is that, whatever you want to call the current system, it is vital that the entities which characterise it, with their significant impact on production, distribution and exchange, should be put into the political spotlight.

“Unfortunately, many supporter of “free markets” are driven to defending the actions of large, centralised entities as apolitical. This perspective is based on the false premise that they are simple conduits for scarcity and consumer preferences, rather than actively determining and influencing these things. It is clear this influence has largely driven us away from what economists typically mean when they speak of a ‘market.’”

I would take that a step further and say that it is a part of the larger problem of economists tending to model their economic actors purely off of “agents” and professional persons, the “rational man” we so often encounter. This probably just done because it is easier to observe and predict the actions of a business or any professional entity(including individual professionals) since in a capitalist society their main goal will be to minimize losses and increase gains. For example, it is fairly easy for us to predict what a trust manager is going to do in response to market changes since his main goals are quite apparent to us. It is much harder to predict what the non professional/expert/agent will do.

Thus its no surprise that the schools of economic thought that rely on methodological individualism of the agent, or the firm as a “secular” entity almost all end up advocating laissez fairre, since their entire premise begins with the assumption that their actors are rational and only motivated by purely economic goals. One must wonder if the entire thing is just an artifact of their flawed methodology.

But while I agree with you that producers play an enormous role, I think its important to keep the big picture in mind, if you focus on one part of the economy too much you can end up getting some clearly flawed ideas (Marxism, Say’s Law,etc.).

But it is still a fascinating proposition. Some of the free marketiers end up fetishizing the firm and forget that both firms and individuals can all have very inneficient or harmful habits and practices that go unnoticed or ignored as long as the income remains higher than the outlays. Some firms may be like the functional alcoholic who refuse to recognize their dysfunction because their functioning remains “just enough” to get by. Just like how Football teams tend to only fire coachs after bad seasons, many firms wait until they have a bad year (or few bad years) until they go back to the drawing board and recognize the bad or outdated parts of their practices. And of course there is the question of what the aggregate effect is of the bad practices of profitable companies on the real economy as a whole. I am fascinated by this question and its broader implications, look at the period of 1914 to 1939(roughly), you had WW1 when generals were using 19th century tactics with 20th century technology to horrific results, you had an economic catastrophe in the late 1920s in which clearly producers misguaged the situation and were blindsided by the economic realities, then you had the 1930s where governments all seemed to respond to that economic catastrophe by doing all the wrong things(Smoot-Hawley, hawkish fed) using outdated or misguided prescriptions. All this seems to indicate a massive misstep on the part of the institutions and professional world where the world around them had changed faster than they were able to adapt (my guess is population explosion and mechanization are responsible for the increase in rate of change). It seems that this era bears some similarities to that one and one must wonder if our current insitutions, professionals and producers are simply unwilling to change or are in denial of our new realities by trusting the “free market” to fix things when in reality they are the ones who are the problem.

One must wonder if the entire thing is just an artifact of their flawed methodology.

I have recently began to wonder if the crudest neoclassical models – such as a perfect competition – are really little more than sets of axioms whose conclusions do not differ from their premises in any meaningful sense. Often, the entire argument seems to be embedded in the assumptions.

Your last paragraph is very interesting. The truth is there is no room for learning in economic models. Take the current crisis in the Eurzone. There are some historical analogies, but overall it is new territory. Hence, the markets (by which I mean bondholders) do not know how to react. They perhaps panicked irrationally at first, and as a result we have very real problems materialising. The widespread inertia of firms is also something that can have big macroeconomic effects, particularly when said firm is large and goes bust because of its unwillingness to adapt.

Think about Biology before DNA was discovered or Geology before plate tectonics was understood, both disciplines had learned a lot but they still lacked a comprehensive model that made everything fit into place. And they didn’t discover them through their old fashioned models, things like DNA were discovered because of advances in different disciplines (chemistry and microscopy). I think economics today is almost like biology in the years before DNA’s discovery or Geology before Plate Tectonics was understood, they know a lot, but they clearly lack a way to get it to all fit in together. Meanwhile the economy continues to be a source of surprise and humility for everyone who tries to figure it out. If economics is going to advance beyond the current complaints it will probably come more from interdisciplinary dialogue with other sciences to gain new insights rather than from continuing to pound away with the same old models.

I’m reading “The New Industrial State” by John Kenneth Galbraith at the moment and he’s arguing a very similar point. Is he the inspiration behind this post? Either way the role of corporations in the economy is a hugely powerful one that needs more attention. Their influence and power have wide ranging consequences.

I actually haven’t read that, no. If there’s an influence for this post it’s ‘The Myth of the Market Economy’ by William Lazonick, which I read a short while back. But some of these thoughts have been in my head for a while.

It would be worth reading NIS and then, as a sequel, James Galbraith’s Predator State. Robert is right–much of what you lay out here was prefigured by Galbraith pere in NIS. But that book also assumed a trajectory for the mid-century firm that turned out not to be accurate. Part of the burden of the Predator State (by Galbraith fis) is to show the continued relevance of his father’s institutional framework (which puts ‘actually existing’ industrial firms at the center of the analysis), in the face of a very different future, for those firms and their relationship to the state, than his farther had envisioned.

You don’t need to love some kind of socialist conglomerate to dismiss Neoclassical theory of the firm…
Some times economists discuss about topics which are widely known among professionals (managers, consultants, researchers, etc.) as if they were talking about something new or very significant when – at best – it’s just a posteriori rationalization of business practices.

“The competitive ideal seems illogical when applied to the real world. Market forces can be inherently uncertain and costly to adjust to. Any firm which is wholly subservient to market forces, and hence has no control over its future, is simply a terrible firm, and a poor prospect for any potential investor, shareholder or worker.”
– Well, competition implies rivalry, increasing market share, trying to exert some kind of control over the enviroment (which is a way of downsizing potential risks, hence a complementary strategy to increase the present value of future cash flows), etc. Competition often impies also an high mortality for new SBE, expecially during their first years of life. Anyway all that above actually IS a competitive market. Maybe it’s not how neoclassical economists discuss the topic, but that’s their problem.
There are more or less oligopolistic market, but that doesn’t wipe out the idea of a market economy. A market economy it’s like a kind of evolutionary ecosystem driven by market forces and yes, institutions and customs do play a role, “big players” exert influences, government spending could have both positive spillover and negative externalities, etc.

“Research and development can ensure a firm always has something new to offer and can adapt, should demand for a product fall or a new release flop.”
– That’s why talking about consumer sovreignity – properly understood – makes sense. We don’t live any more in a world where a black T – model can ensure the prosperity of an automaker.

“The challenge for a firm is to establish a degree of control over its respective market; the degree to which it manages this will be a determinant of its success; its ‘competitive advantage.’ Hence, many of a firm’s actions have the purpose of cementing that firm’s position in the marketplace, rather than simply responding passively to outside market forces.”
– Quite true, Porter told us so many years ago. But a) the possibility of gaining a competitive advantage is one of the main feature of a market economy compared to an hyper-regulated or a state owned one, b) the possibility of losing it – as it regulary happens when a firm becames unable to keep the pace with newcomers is another market feature as the same fact that almost never a competitive advantage is something static.

“The implication is that, whatever you want to call the current system, it is vital that the entities which characterise it, with their significant impact on production, distribution and exchange, should be put into the political spotlight.”
– Only if you think that almost all resources should be allocated through a political process disregarding the importance of property rights, freedom of contracts and rule of the law. But I’m not so naive to believe in a “pure” democracy: history is a graveyard of aristocracies (even if the original word was élites and not arisistocracies),

Anyway all that above actually IS a competitive market. Maybe it’s not how neoclassical economists discuss the topic, but that’s their problem.

As I say, a firm’s ‘competitive edge’ could really be thought of as the degree of control it has over market forces. This is not how neoclassical economists discuss innovation. It’s not necessarily an ideological point – as I imply, these firms with a ‘competitive advantage’ can be a source of massive innovation and growth.

That’s why talking about consumer sovereignty – properly understood – makes sense. We don’t live any more in a world where a black T – model can ensure the prosperity of an automaker.

Consumers have power, but your average consumer is more reliant on a producer than vice versa. As I said, this is partly because the producers are the ones with all the stuff; it is also true that there are fewer producers then consumers. Ultimately the producer decides which product gets made and makes consumers aware of it and try to persuade them to buy it. Consumers can, of course, reject a product, but for a large company having one product rejected is not necessarily disastrous. Producers simply last longer and have more resources, information and potential strategies than consumers.

There are more or less oligopolistic market, but that doesn’t wipe out the idea of a market economy. A market economy it’s like a kind of evolutionary ecosystem driven by market forces and yes, institutions and customs do play a role, “big players” exert influences, government spending could have both positive spillover and negative externalities, etc.

It’s really just a framing issue. Are companies islands in a sea of market forces, or are markets infrequently found relations in between large institutions and bureaucracies? Personally, I’d suggest many of our dealing dont’ take place in anything like the ‘market’ envisaged by neoclassical economists, with constant bargaining, large numbers of players etc.

Only if you think that almost all resources should be allocated through a political process disregarding the importance of property rights, freedom of contracts and rule of the law. But I’m not so naive to believe in a “pure” democracy: history is a graveyard of aristocracies (even if the original word was élites and not arisistocracies),

Political philosophy is the study of who gets what and why. All economic systems depend on distributions that are a result of certain institutions. In the case of large companies, shareholders meeting to evaluate and discuss strategy is no different – just because the institutions invovled are normalised and hidden, doesn’t mean they aren’t there.

“Political philosophy is the study of who gets what and why. All economic systems depend on distributions that are a result of certain institutions. In the case of large companies, shareholders meeting to evaluate and discuss strategy is no different – just because the institutions invovled are normalised and hidden, doesn’t mean they aren’t there.”

I read a very interesting law review article once that discussed in depth a comparison of corporations in which employees owned a large portion of the shares versus the standard American public corporation in which thousands of different shareholders make up the ownership. I will try to find it, but after reading it I was convinced that the ownership makeup of corporations has a huge effect on not just the goals and nature of the institution itself, but also the functioning of the entire economy where that corporate form dominates.

“Hence, no firm would go to an investor, shareholder or bank and say “I have a product, let’s see whether the market likes it or not;” what is expected is a clear strategy.”

This is far too strong an assertion. What really happens is a combination of these two. I have been involved in several Silicon Valley start-ups, and when they go after funding, everyone wants to see a business plan, but everyone is also aware that the final business strategy will be a combination of the original business plan and flexibility in reaction to the market.

In fact I am involved in a small start-up right now, and we adjust the exact characteristics of our proposed product on an almost monthly basis as we find out more about what the market demands.

In fact I am involved in a small start-up right now, and we adjust the exact characteristics of our proposed product on an almost monthly basis as we find out more about what the market demands.

However, your business is small. If it were larger and you enjoyed a greater degree of market power (which perhaps you will in the future) then this wouldn’t be the case, right? My point is that, given competing firms, we would expect those with a competitive advantage to grow larger and cement their position in the market place, becoming more in control of market forces. If every firm were like yours, a large part of my post wouldn’t apply. However, over time, large players would establish a competitive advantage and market power.

The NY Times ran a story recently ostensibly about food, but with some pretty strong ties to the broader subject of consumer sovereignty and the harmful emergent effects of Our Favorite Dominant Economic System.

It took me a running start to get into this article, but once it gets going it gets goddamn going. Holy hell.

No, I just looked at the Wikipedia page for firms and wrote a blog about it.

Actually, I linked directly to one of Williamson’s theories, so perhaps it’s you who needs to do your research.

Half of these theories do not address my problem, which is that organisation and management play a crucial role in creating competitive advantage and firms actively control and create markets.

Take Williamson. He explicitly says that ‘at first, there were markets’ and firms ‘arose’ out of them due to various ‘frictions’ (eg asset specificity, Coase’s transaction costs).

The half that do appear to offer some promise are anything but mainstream approaches. If you and everyone else acknowledges the flaws in the neoclassical theory, maybe economists should stop using it in their theories, teaching it, and devising policy advice based on it.